Financial Markets & Instruments — Introduction
(1802 Words, 11 Minutes)
Let’s introduce this course with a global overview over financial markets. If we take a step backward, we’ll see the financial markets are a part of a financial system which includes :
- financial markets
- financial institutions
- financial services
- financial instruments
- money
The financial markets are platforms (physical or virtual) where financial assets such as stocks, bonds, currencies, and derivatives are traded. They play a central role in the economy by matching savers (those with excess capital, also called buyers) with borrowers (those in need of funds, also called sellers), facilitating capital allocation, liquidity, and price discovery.
Financial institutions are companies or organizations that provide financial services to participants in the economy. Their main role is to act as intermediaries between savers and borrowers, helping to channel funds through the financial system. Banks, insurance companies, investment firms, pension funds are examples of financial institutions.
Financial services are the products and activities provided by financial institutions that allow individuals and businesses to manage money, access credit, invest, insure, and transfer funds. These services are the practical application layer of the financial system. They can be of several kind : loans, savings accounts, investment advice, asset management, insurance policies, payment processing.
Financial instruments, in the sense of the Internationl Accounting Standards (IAS), are legal contracts between two or more parties, which can be traded and settled, that define conditions under which one party (the buyer) receives benefits (financial asset) and the other party (the seller) incurs costs (financial liability or equity instrument). We call portfolio a collection of financial instruments hold by an investor.
Money is any asset that is generally accepted as a medium of exchange, a unit of account, and a store of value in an economy. It facilitates trade, provides a standard for pricing goods/services, and preserves value over time (to varying degrees).
In the financial markets, we can find participants from the real economy (retail investors such as households and individuals, firms and governments) as well as financial intermediairies which can be of two types : monetary financial institution (bank, central banks or pension funds) and non-monetary institutions (eg: hedge funds or family offices).
Why do we need financial markets ?
Financial markets might seem like a big and complicated machine but at their core, they help make money flow where it’s needed most. Here’s what they really do, and why they matter.
Finance the economy
When a company wants to grow by building a new factory, hiring more people, or launching a new product or market. They can’t always pay for it all with their own money. So, they turn to the financial markets to raise money:
- By issuing bonds, they borrow money from investors (like getting a loan from thousands of people).
- By selling shares, they let people become part-owners of the company.
And governments do the same thing! For example, France issues government bonds through an agency called Agence France Trésor (AFT). These are called OATs (Obligations Assimilables du Trésor). When people buy those bonds, they’re basically lending money to the French state, and in return, they get paid interest over time.
We can take a moment to discuss the difference between a bond and a stock. Remind this : A bond is a loan. A stock is ownership.
When you buy a bond, you’re lending money to a company or a government. In return, they promise to pay you interest regularly and give back the full amount at the end (called the maturity). When you buy a stock, you’re buying a small piece of ownership in a company. If the company does well, your shares become more valuable, and you might earn dividends (a share of the profits). But you also take more risk : if the company does badly, your stock could lose value.
Transfer and manage risks
Imagine a bakery that buys tons of flour every month. If flour prices suddenly shoot up, it could really hurt their business. To avoid surprises, they can use derivatives (special financial contracts) to lock in prices ahead of time. That way, they can hedge against price changes and sleep better at night.
This is one of the most useful things financial markets do: they allow businesses to transfer risk, so they can focus on what they do best — like baking bread — without worrying as much about market surprises.
Provide Liquidity and Transparency
We’ll talk a lot about liquidity in this course so it’s important that you understand what it represents. We’ll start with this definition :
Liquidity is how quickly and easily you can turn an asset into cash without losing value.
Think of liquidity like water :
- Cash is like water in a glass : ready to drink anytime.
- Real estate is like ice : it’s still water, but it takes time to melt (sell).
- Rare collectibles are like a brick of ice stuck in the freezer : hard to melt, hard to sell fast.
Liquidity depends on how many actors wants to sell and buy a product.
Let’s say you buy shares in a company. If you suddenly need cash, you can sell those shares on the stock market almost instantly because of the high level of liquidity of this market.
And because prices are constantly moving in the markets, they also send signals about what people think something is worth. If the price of a company’s stock is falling, it might reflect bad news. If a government bond is yielding more than usual, it could mean people think there’s more risk.
All of this information helps investors make smarter decisions and protects them (at least a bit) from things like fraud or shady behavior.
What are financial instruments ?
Let’s get something straight first: financial instruments are the actual things being bought and sold in financial markets. They’re like the “goods” of the finance world. Some are simple (like shares or bonds), others are more complex (like options or swaps). But in all cases, they represent a financial relationship between two parties.
There are two big families of financial instruments.
Cash Instruments
These are the more “straightforward” ones. They can be:
- A financial asset: something with value, like cash, gold, or a legal claim to real stuff (like property or commodities).
- A financial security: a tradable claim on a company’s assets or income — like stocks or bonds.
Settlement is usually quick, often within 2 business days (called T+2 in market terms). Some examples could be an Apple stock or lending money to a company via a corporate bond.
Derivative Instruments
These are a bit more advanced. A derivative is a financial contract whose value is based on (or “derived from”) something else — called the underlying asset which can be a stock, a commodity like oil or and index. A full section at the end of this course will be devoted to derivatives.
In the case of derivative instruments, the deal usually settles in the future, at a set date or within a specific time window. Think of derivatives as the betting slips of the financial world : you’re not buying the thing, you’re buying a deal based on how that thing behaves. For examples, a future contract to buy 100 barrels of oil next month or a stock option giving you the right to buy Google shares at $1000 (even if they hit $1200).
Two different logics
A cash instrument is like buying a bottle of orange juice, you own it now. A derivative is like signing a deal to buy that juice in a week at today’s price, hoping the price goes up so you make a profit.
That’s why real assets (like buildings) and securities (like stocks/bonds) show up on the balance sheet while derivatives, on the other hand, are typically off-balance sheet because they’re contracts, not physical or owned things. You “own” a bond. But you don’t “own” a future, you’re just committed to a deal about it.
Now that we’ve seen what is being traded — whether it’s a bond, a stock, or a futures contract — let’s look at where these instruments are created and exchanged: the primary and secondary markets.
The two stages of Financial Markets
When we talk about financial markets, we’re really talking about two big stages where the action happens: the Primary Market and the Secondary Market. Let’s break it down.
The Primary Market: where it all begins
This is where new financial instruments are born. In the primary market, a company (or government) issues a brand-new security that has never been traded before. The main goal? To raise money.
A few typical examples:
- Initial Public Offering (IPO): A company goes public and sells its shares to investors for the first time.
- Follow-On Public Offering (FPO): A company that’s already public wants to raise more money and sells more shares.
- Bond issuance: Governments or companies sell new bonds to fund projects or cover expenses.
You can think of the primary market as a “fundraising event” with the company on stage, and investors in the audience, deciding whether to buy a ticket (or in this case, a piece of the company).
The Secondary Market: where the real action is
Once those shares or bonds are issued, they don’t just disappear : they go to the secondary market, where investors buy and sell them among themselves.
The company doesn’t get any money in these trades. The goal here is different:
- Provide liquidity
- Let investors manage risk or rebalance their portfolios
Think of it like this: The primary market is when you buy a car from the manufacturer. The secondary market is when you sell that same car later on Craigslist or a dealership.
There are two main types of secondary markets:
Over-the-Counter (OTC) Markets with no central exchange. Traders (fund managers, banks, treasurers) deal directly with each other. As a consequence, contracts can be customized (size, maturity, etc.). OTC Markets are o ften used for bonds, derivatives, or foreign exchange (FX).
Organized (On-Exchange) Markets All trades go through a central exchange or clearing house. Contracts are standardized (you can’t just change the rules) which provides a High transparency and efficiency.
The Clearing House
A clearing house is a middleman in financial markets that sits between buyers and sellers to make sure every trade actually happens smoothly and safely.
The main role of the clearing house is to guarantee and settle trades between market participants, while managing the risk that one side doesn’t hold up their end of the deal.
The core actions of a clearing house are :
- Trade Confirmation : Makes sure both sides agree on the terms of the trade (price, quantity, date).
- Clearing : Calculates who owes what to whom after all trades are netted out.
- Settlement : Ensures the actual exchange of money and assets happens.
- Risk Management : Collects margin (a kind of deposit) and monitors positions to limit risk.
- Guaranteeing Trades : Steps in if one party defaults, meaning that the clearing house guarantees the trade.
Conclusion
Now that we’ve seen what financial instruments are and where they get issued and traded, you’ve got a solid foundation of how the financial markets actually work.
From bonds and stocks to futures and options, everything passes through this structured system which is a mix of creation (primary market), exchange (secondary market), and coordination (via institutions like clearing houses).
But there’s one thing that influences almost every financial decision, from the price of a bond to the value of a derivative: interest rates. They’re everywhere in finance and in the next section, we’ll explore what they are, why they matter, and how they affect everything from borrowing to investing.